Looking Ahead-Seeing Green in Red

Each quarter we prepare our near term Look Ahead. Our goal is to attempt to frame the macro-economic and asset allocation issues we face when trying to invest wisely.

Below is a link to a video version of our Look Ahead for your review.

Q3 2015 Look Ahead

If you prefer the pdf version with no audio narrative you can download it here

Q3 2015 Look Ahead pdf

Great_Wall.png

The blog, on the other hand, is an opportunity to expand upon some key points in the Look Ahead.

News on China has been developing at a rapid pace. With all that has been going on, allow me to expand some thoughts on China that could not be addressed in the Look Ahead.

China has seen their markets rise over 150% YTD only to see it give back almost 60% of those gains in the last 3 weeks. [i]

China_composite_SSE.PNG

Realize most foreigners do not own Yuan denominated Mainland China Shares (A - Shares). Generally we own shares listed in Hong Kong (H - Shares) which have not seen such violent price behavior and are denominated by the Hong Kong Dollar.

The Chinese government has taken some extraordinary steps to stem the free fall in their stock market: [ii]

June, 27 (Saturday) – China’s central bank cuts guidance lending rates and trims the amount of cash that some banks must hold as reserves.

June, 29 – Markets continue to crash. The state-backed provider of margin financing, China Securities Finance Corp, publicly says that the risk of margin trading is controllable and margin calls are relatively small. Later in the day, China says it will allow pension funds managed by local governments to invest in the stock market for the first time.

July, 1 – Stocks tumble. After markets close, the Shanghai and Shenzhen stock exchanges announce plans to lower securities transaction fees by 30 percent from August.

July, 2 -- The CSRC announces relaxation of rules on margin trading before market open, lowering threshold for individual investors to trade on margins and expanding brokerages' funding channels.

July, 3 - China Financial Futures Exchange (CFFEX) suspends 19 accounts from short-selling for one month.

July, 4 (Saturday) -- China's top 21 securities brokerages pledge to invest at least 120 billion yuan ($19.33 billion) collectively to help stabilize the country's stock markets.

July, 4 – Twenty-eight Chinese companies planning to list on the country’s stock exchanges say they will suspend initial public offerings.

July, 5 (Sunday) -- China state-owned investment company Central Huijin Investment Ltd says it has recently purchased exchange-traded funds (ETFs) to support the market and will continue to do so.

July, 5 – The CRSC announces that People’s Bank of China (PBOC) will inject liquidity directly to the state-backed margin finance company to stabilize the tumbling stock market.

July, 6 - Main stock indexes opened up more than 7 percent on rescue measures, but gave back most of the gains during the day to close up at 2.4 percent. Companies continue to rush to halt trading in shares.

July, 8 - Chinese regulators come out with another series of support statements and measures, most of them in the morning before market open, in particular raising margin requirements for short positions taken against the small-cap CSI500 Index, and making it easier for insurers to buy blue chips. The CSRC warns of "panic" and "irrational selling" in the market.

At this point more than 40 percent of listed companies have successfully requested trading halts.

Why would the Chinese government do this? [iii]

  • The United States, to date, successfully intervened in banking, markets, asset purchases and moral hazards.
  • China, has more investors than Communist Party members. There are currently 90 million Chinese investors to only 87.8 million Communist Party members.
  • 40 million investment accounts were opened year to date through May vs only 1.1 million people joining the Communist Party.
  • The broader Chinese population has a growing interest in investing their savings. Over 7 million new retail accounts were opened in the month of June alone.
  • A recent study suggested 66% of new investors in China did not complete high school.
  • China’s transition to a consumer economy needs help.

Simply put, it's in China’s best interest to defend asset appreciation (sound familiar- think USA 2008-2009).

As you may recall, I wrote extensively on my visit to China this year and my conclusions. If not, you can read our post here. In summary, China is following a traditional path of moving from an emerging economy ("backward") to one of a sustainable developed nation ("forward").

China’s goal at the end of the process is to have a more consumption driven economy, like we have in the United States, as opposed to an economy driven by capital improvements, like the majority of emerging economies.

As part of this process, China needs to do everything possible to convince its citizens to part ways with their massive savings. Perhaps the largest per capita savings as a % of GDP in the history of the world. [iv]

Savings__GDP.png

Part of China’s consumption aspiration is to get the average citizen to invest. Perhaps the hope is a higher Chinese stock market, as inflated equity assets help locals feel more confident and buy more domestically. Similar to the "Wealth Effect" we are currently experiencing here in the U.S. [v]

China_Consumer_Spending.png

One must look no further than the graph above to see the Chinese consumer is confident in spending more.

In any case, the popping of the domestic China equity bubble may not adversely impact the move from "backwards" to “forwards.” The average Chinese investor keeps 45% of financial assets in cash and bank deposits with only 20% in equity or stock. China, will continue to cajole their citizenry into spending and consuming. [vi]

While there are certainly challenges in the Chinese banking system, the news of their delinquent loans is overdone at times. [vii]

Problem_Loans.png

There will be overall slower macro-economic growth as part of the conversion to a consumption-driven economy. Not every Chinese company will be a winner; those catering to a strong Chinese consumer will be winners. It will certainly be a painful process along the way, but if the Communist Party wants to stay in control they will need to make the conversion. We will continue to find ways to prudently invest in China, especially through Hong Kong with a current PE of 8.59, making it one of the best global valuations.

Seeing green in Communist Red takes perspective. We should prepare for more volatility and action from the People’s Bank of China. The transition from an emerging market economy to a consumer driven, developed economy is well underway but far from complete. We will be following the developments closely.

If you have questions or comments, please let us know as we always appreciate your feedback. You can get in touch with us via Twitter, Facebook, or you can email me directly. For additional information on this, please visit our website.

Tim Phillips, CEO – Phillips & Company

References:

[i] Googlefinance.com. 1 yr. Shanghai and Shenzhen indexes

[ii] Reuters. (July, 08 2015). Timeline of China’s attempts to prevent stock market meltdown

[iii] Bloomberg. (June, 06 2015). There Are Now More Stock Traders in China than Communist Party Members

[iv] Nielsen. (Oct 2010). Savings as % of GDP

[v] TradingEconomics.com. (June 2015). China Consumer Spending

[vi] Barrons. (Jan, 26 2015). A Matter of Trust

[vii] Vontobel Asset Management. (May 2015). What’s Driving the Chinese Equity Market?